US Fed's desicion must be used to put our house in order

We have to use this respite to "create a bulletproof national balance sheet and growth agenda". Central to any such “bulletproofing” is low and stable inflation.

By Mythili Bhusnurmath

From poster boy to stick-in-the-mud central banker. In little over a fortnight, the markets' love affair with the new Reserve Bank of India (RBI) governor Raghuram Rajan seems to have all but ended. But even as the BSE Sensex ended on Friday 380 points lower on the back of a surprise 25-basis-point hike in the repo rate — the rate at which the RBI lends to banks — another, more enduring love affair with the beleaguered aam aadmi might have begun.

Setting at rest all doubts about where his priorities lay, Rajan played true to central-bank-governor form. He put price stability, or the internal value of the rupee, as he put it, first. In hindsight, we should have been prepared for this. In his first statement on taking over as governor on September 4, he'd said as much, "The primary role of the central bank...is to sustain confidence in the value of the country's money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures."

So, the RBI's move to tame inflationary pressures and, more, anchor inflationary expectations — never mind that most of these pressures come from food inflation — should not have come as a surprise. But markets, blindsided by the dovish stance of the US Federal Reserve, our faltering growth numbers and, let us admit, Rajan's stint in North Block, failed to read the signs. As did most columnists, including this one.

So, the best guess was that the governor would tweak the exceptional liquidity-tightening measures announced in mid-July. Instead, he pulled a rabbit out of his hat. Unfortunately, in the topsy-turvy world we live in, the hike in repo rate is being perceived as negative when it is actually long-term positive. Just as the Fed action is perceived as positive when it is actually long-term negative.

ACTION AS LOUD AS WORDS

Most importantly, his action is not at odds with his statement on assuming charge. "It is not to say we will never surprise markets with actions; a central bank should never say 'Never'. But the public should have a clear framework as to where we are going and understand how our policy actions fit into that framework."

Has he succeeded in doing that? Broadly speaking, yes. It is pretty clear the RBI is getting back to doing what a central bank is best equipped to do: ensure price stability.

The signal does get a bit diluted when the hike in repo rate is coupled with a substantial (75-basis-point) reduction in the interest rate on the marginal standing facility (MSF) at which the RBI lends banks to tide over a liquidity crunch. But this is only a reversal, and that too only a partial reversal, of the sharp increase in the MSF rate earlier. It should not be construed as being at odds with a hawkish stance.

The reality is that almost all our present ills, whether loss of competitiveness, fall in savings in financial instruments or high current account deficit, can be traced to high and persistent inflation.

Starting late 2009, consumer price inflation has been close to double digits as a result of both supply and demand pressures. While supply pressures came from elevated domestic food prices and rising global prices of oil and other commodities, demand pressures stemmed from rising incomes and release of pent-up demand as recovery began.

The combination proved lethal. The net result, a widening savingsinvestment gap, manifested itself in an unsustainable current account deficit; with all its attendant ills. We were left virtually defenceless when the tide in capital flows began turning. To be sure, we had a far more respectable stockpile of reserves — close to $300 billion — than at the time of the 1991 crisis.

MONEY WITH A RETURN TICKET

But we are also far more globalised and, hence, more affected by capital flows, and more dramatically by outflows, as evidenced during the May-August 2013 period when sharp rupee depreciation wrought severe damage on the real economy.

In the circumstances, the only lasting remedy, even if it does entail a thumbs-down from the markets, is to rein in inflation; or, as Rajan puts it, "preserve the internal value of the rupee". If the internal value of the currency is preserved, the exchange rate, in Rajan's words, "will adjust accordingly".

NOW THAT'S SPOON-FED

The message is clear. We got an unexpected reprieve, thanks to the Fed's surprise decision to defer the tapering of its bond-buying programme that saw it pump in $85 billion every month. But we have got to use that respite to "create a bulletproof national balance sheet and growth agenda". Central to any such "bulletproofing" is low and stable inflation. In a scenario where, in the RBI's assessment, wholesale price inflation is expected to be higher than initially projected, that can mean only one thing: a hike in the repo rate.